By Stephen Hsu, SVP, Head of Model Risk Management, Pacific Western Bank

CECL 2019 is taking place in New York City on 27-28 March, 2019 – find out more here www.cefpro.com/cecl

Can you please tell the Risk Insights readers a little bit about yourself, your experiences and what your current professional focus is?

I am SVP, Head of Model Risk Management for Pacific Western Bank. My experiences include CECL, stress testing, BASEL, model governance and capital management. Currently in this role, I oversee model risk management function in the Bank and lead the Bank’s model risk management strategy, initiative and practice including model governance, model risk appetite, model inventory, risk assessment, model validation, model risk reporting, etc.

Before joining Pacific Western Bank, I was a Director in KPMG, leading model validations for CCAR/DFAST PPNR and credit loan loss models in top-tier US and global banks. Prior to KPMG, I worked for MUFG in several roles, including Director of Economic Capital Group, AMA Operational Risk Management Group, etc. Prior to MUFG, I was a VP for Bank of America in Capital Portfolio and Risk Analysis Group. I hold my PhD in Economics from University of California, Los Angeles.

Can you provide an overview of what you hope to discuss at the event and why the topic is so important?

Both CECL and stress testing play critical roles in capital planning; therefor a holistic and coherent estimation process or governance structure is needed to make sense of projected revenues, losses, reserves, capital ratios and capital buffer. Various assumptions are used in CECL and stress testing; as a result they should be aligned so that one assumption used in one place will not contradict to its counterpart used in the other. Scenarios used in CECL and stress testing should also be coherent so that the behaviours of macroeconomic variables, for example, in both CECL and stress testing process are harmonized. Incoherent CECL and stress testing process will potentially lead to confusing results and disconnected business strategies in capital planning.

Why is it so important for institutions to start looking more holistically to bring all aspects together and avoid disparate processes? How can this benefit an institution?

From risk management and capital planning perspective, the Bank should have a holistic view on the impact of projected revenues, losses, reserves, capital ratios and capital buffer to evaluate what planned capital action, i.e. stage of early warning and escalation process in capital planning, is triggered. A coherent view from CECL and stress testing can provide a better assessment of the expected uses and sources of capital.

What the Bank should avoid here is that people work in silos, and there is no coherent story to tell as the Bank. Banks have seen this happen before in CCAR process, where few assumptions used in PPNR, for example, were different from those used in credit risk management department or Treasury department. Regulators before also pointed out this inconsistency.

How can CECL results be used to influence capital planning?

Portfolio optimization is one. It is related to that how much capital is needed based on most-likely increased reserves at day-1 adoption. Given that CECL is lifetime loss estimation, in general, more reserves will be needed, especially the more loans on the balance sheet with longer maturities (such as 30 Year mortgage). As a result, a bank might consider changing its portfolio concentration or product mix to optimize the cost and return in capital planning.

Earnings volatility is another one. It is related to the procyclicality nature of CECL. Based on design, there will be more losses estimated by CECL at the beginning of the economic downturn, and as a result, it increases the volatility of earnings and cuts back more in a bank’s lending ability. This amplifies the need to manage the uses and sources of capital through economic cycles and it should be taken into consideration in on-going capital planning.

What are the benefits and potential challenges of using one model inventory?

Based on SR 11-7, a Bank should have a specific party, most likely the Model Risk Management team, to maintain a firm-wide inventory for all models. Therefore, the first benefit of using one model inventory is to streamline the process for Model Risk Management team to efficiently monitor all the activities from CECL, stress testing and capital models, such as model validation schedule, model changes, model assumptions and limitations, model performance monitoring results, etc., in one place. Another benefit is to streamline the process of model risk aggregation. Having all these models in one model inventory can make it easier for Model Risk Management team to keep track of all the relations between different models (e.g. upstream and downstream models) and as a result to measure aggregate model risk in the Bank. Since there are a lot of information contained in any model inventory, the potential challenges of using one model inventory is to gather all the information needed in time from each line of business involved in CECL, stress testing and capital models.

How do you see the impact of CECL evolving over the next 6-12 months?

Most of the banks should already start their parallel run by now. Banks will analyse the impact and feedback from their CECL parallel run to tune up their methodology, implementation and capital strategies. In particular, CECL needs to be run frequently and reported within a tight deadline, so a streamlined production environment is critical to ensure that the data quality is checked and CECL is estimated accurately and timely. In addition, banks will adjust their capital planning, if needed, based on the outcome from parallel run. Given that some portfolios will need more reserves than the others under CECL methodology, portfolio concentration and product mix should be revisited.